I've had a few people ask me about mezzanine finance, these are finance packages that can offer anything up to 30%pa, usually to cover a property development.

I generally don't recommend them because I consider them far too risky (especially compared to shares, because shares are so much more tax efficient you can get a much lower return from shares to do as well as a mezzanine investor on an after tax basis), but here goes:

If a property development company wants to borrow $10,000,000 to build a retirement village at 10%pa they will need to find a lender.

They package up this mortgage into a finance package to suit a number of different investors.

They sell $6,000,000 worth of first mortgage security at 6%pa to risk adverse investors. These guys have first call on their money if the project goes wrong, and generally because of the 50% loan to value ratio these notes are highly secure. Banks often provide this finance.

They sell $2,000,000 worth of second mortgage notes to investors at a rate of 8.5%pa. These investors take on more risk, because they only get paid after the first mortgage note holders get paid, but as long as the project is mostly sold and the whole thing more or less breaks even they will get their money and their 8.5%.

Finally, they sell $2,000,000 worth of "mezzanine" finance notes at the very high interest rate of 23.5%. These guys are last in line. If the project fails to be fully sold these investors could well make a loss, perhaps even a total loss. They are the most junior of creditors so they aren't entitled to anything.

$6,000,000 * 6% + $2,000,000 * 8.5% + $2,000,000 * 23.5% = $360,000 + $170,000 + $470,000 = $1,000,000, which is 10% interest on $10,000,000. In this way they can offer a package of risk/return profiles for the investment so all investors can say they got what they deserved. Risk adverse investors get their return and nobody complains, but if everything goes poorly the junior note holders have to console themselves with the knowledge that they are risk tolerant investors who should have seen this coming.

Last in line is the property developer, who won't get anything until all creditors are paid.

Yes, most property developers do get paid, which means of course that the mezzanine investors must also get paid, but the fact is you have a 100% downside risk, and you only need a few of those to wreck your portfolio completely.

Because of the tax efficiency and the aggressive risk profile, they suit wealthy investors with low tax rates. Thus, typical mezzanine investors are:

• the non-working spouse of a wealthy investor

• self managed super funds

• corporate investors (with a 30% tax rate)

• thrill seekers, people so risk tolerant that they are willing to borrow money (home equity loan) at 7%, to get that 23.5% return.

I'm really not crazy about mezzanine finance on the whole, I'm sure the rewards are there and they may suit some people, but I personally prefer negative gearing into shares and property, after tax these probably offer a similar return but are less risky (over the long term, since the longer you hold a diversified share portfolio the closer to 100% probability of profit, as opposed to mezzanine finance which is risky on any time frame).